Hedging by Gold Mining Companies
It
is natural for a gold mining company to consider hedging against prices of
gold. Typically it takes several years to extract all the gold from a mine.
Once a gold mining company decides to go ahead with production at a particular
time, it has a big exposure to the price of gold. Indeed a mine that looks
profitable at the outset could become unprofitable if the prices of gold
plunges.
Gold
mining companies are careful to explain their hedging strategies to potential
shareholders. Some gold mining companies do not hedge. They tend to attract
shareholders who buy gold stock because they want to benefit when the price of
gold increases and are prepared to accept the risk of a loss from a decrease in
the price of gold. Other companies choose to hedge. They estimated the number
of ounces of gold they will produce each month for the next few years and enter
into short futures or forward contracts to lock in the price for all or part of
this.
Suppose
you are Goldman Sachs and are approached by a gold mining company that wants to
sell you a large amount of gold in 1 year at fixed price. How do you set the
price and then hedge your risk? The answer is that you can hedge by borrowing
the gold from a central bank, selling it immediately in the spot market, and
investing the proceeds at the risk-free rate. At the end of the year, you buy
the gold from the gold mining company and use it to repay the central bank. The
fixed forward price you set for the gold reflects the risk-free rate you earn
and the lease rate you pay the central bank for borrowing gold.
-
Sujit Kapadia
